We have seen various market dynamics impact the high yield bond market and some selling pressure ensue over the past couple weeks; however, at the end of the day, we do not see that the opportunity in the high yield market has evaporated or that investors should run for the exits—if anything, lower prices can present a buying opportunity. As an active manager, we have the ability to sell securities that have appreciated in value and/or sit at large premiums, and buy securities that have fallen in price during this widening; passive, index-based products are limited in their ability to do this.
In terms of some of the market impacts on high yield over the past couple weeks, one issue raised was Fed Chair Yellen recently expressing concerns on the valuations in the high yield market. Of note, she also commented on over-valuations in biotech and social media stocks. It seems a bit odd the Yellen is giving us investment advice, though nothing surprises us coming out of DC these days. I thought the Fed’s “statutory mandate” was “maximum employment, stable prices, and moderate long-term interest rates,” and then “explaining its monetary policy decisions to the public as clearly as possible”1? We also saw James Bullard, President of the St. Louis Fed (though a non-voting member of the Fed), commenting that the Fed may need to raise rates more quickly than some have expected as the unemployment rate falls, inflation picks up, and macroeconomic conditions improve.
We think that investors need to keep these comments in perspective. Yes, the high yield market has seen a large run up over the past several years and yields are low relative to history, but that is because interest rates have been at or near all-time lows for years (the Fed’s doing), pressuring yields in all fixed income securities as investors search for places to generate returns. However, comparatively, we believe the high yield market, outside of the large flow names widely held by the index-based products, still looks very attractive. Additionally we sit at a spread-to-worst level (the spread or yield-to-worst advantage over the yield on a comparable maturity risk free security/Treasury) of 428bps today, which is well over the all-time lows on spreads of 271bps, set in 2007 according to the Credit Suisse Index.2 And of note, this index has also spent nearly one-fifth of time at spreads sub-400bps over the past nearly three decades3 (see our blog “A Perspective on High Yield Spreads”). So from a valuation perspective we do not see the high yield market as extreme, especially in the context of what is expected to be a low default environment (well below historical averages) for the next couple years.4
Additionally, we ultimately don’t see that the economic conditions are supportive of higher rates in the near to medium-term. Data is open to interpretation, but the most recent data doesn’t seem to be indicating the strong Q2 recovery many in the stock market had hoped. For instance, we’ve seen some disappointing retail sales of late and the housing market is showing some signs of cracks (weak housing starts). Furthermore, yes, we are seeing the unemployment situation improve, but underneath the recently reported number is the reality that the job creation is coming from part time, low-wage work. There is still a large portion of working age people that are under-employed or that have given up looking for work all-together.
Above and beyond this, we see a long-term drag on rates coming from demographics, as the demand for fixed income products heat up (see our piece “Of Elephants and Rates”). If anything, if you look at rates, those actually buying and selling bonds don’t seem to be getting the memo that rates will be rising soon, as the 10-year now sits at the lowest level that we have seen over the last 13 months.5 For evidence of this demand in Treasuries, look to the bid-to-cover ratio on all notes and bonds sold so far in 2014, which is over 3.0. This means there was three times the demand as compared to issuance. Additionally, keep in mind, just because the short-end of the curve might rise, that doesn’t necessarily mean the medium and longer end that corporate debt is more sensitive to will rise. Ultimately these yields are determined by supply/demand, not necessarily Fed policy.
There has been a step back in the high yield market over the past couple weeks, nearly a 50 bps of spread-to-worst widening on the Band of America High Yield Index.6 We view that as healthy—no market should always, indiscriminately be going straight up. We don’t believe that anything has fundamentally changed for this space or for the underlying companies, and we have even continued to see a well-functioning new issue market for high yield despite some of the pressure in the secondary high yield space. While there could always be a surprise, we do not see any systemic shocks on the horizon. There are certain areas that are of concern (such as the massive issuance of CLOs so far this year) but these areas are small and well contained. So as we look at the current market, we would view these lower secondary prices for high yield bonds as a potential buying opportunity for secondary market players who are able to take advantage of them.